31. Since October 2011, the stance of monetary policy shifted to addressing increasing growth risks as reflected in the slowing down of the economy. The monetary policy response was, however, constrained because of inflation broadening and persisting at a level much above what is conducive for sustained growth. The risk of expectations getting entrenched in the event of a premature change in the policy stance was significant. Notwithstanding the constraints, the CRR was reduced cumulatively by 125 basis points during January-March 2012 to prepare liquidity conditions for a front-loaded 50 basis points reduction in the policy repo rate in April. However, the Reserve Bank had to pause in its policy rate reduction as the expected complementary policy actions towards fiscal adjustment and improving the investment climate did not follow, and inflation risks persisted. Nevertheless, the Reserve Bank persevered with efforts to ease credit and liquidity conditions through a 100 basis points reduction in the statutory liquidity ratio (SLR) in July and a cumulative 50 basis points reduction in the CRR during September-October.

32. Against this backdrop of global and domestic macroeconomic conditions, outlook and risks, the policy stance in this review is shaped by two major considerations.

33. First, headline WPI inflation and its momentum edged down in November-December on the back of softening of non-food manufactured products inflation, even though food inflation has risen, adversely impacting households’ inflation expectations. The staggered increase in diesel prices announced earlier this month will percolate through to overall costs and inflation; however, these price pressures will dissipate over time, and the consequent reduction entailed in the fiscal deficit will bring about an enduring reduction in inflation and inflation expectations. At the same time, still high input costs and wages continue to impart upward pressures on prices. Accordingly, it is critical that even as the monetary policy stance shifts further towards mitigating growth risks, the objective of containing inflation and anchoring inflation expectations is not de-emphasised.

34. Second, growth has decelerated significantly below trend through 2011-12 and 2012-13 so far and overall economic activity remains subdued. On the demand side, investment activity has been way below desired levels and consumption demand has started to decelerate. External demand has also weakened due to the slowdown in global growth. On the supply side, constraints in the availability of key raw materials and intermediates are becoming binding. In turn, this is being reflected in a widening of the CAD with adverse implications for external sustainability. While the monetary policy stance has sought to balance the growth-inflation dynamic through calibrated easing, it is critical now to arrest the loss of growth momentum without endangering external stability. The moderation in inflation conditions provides the opportunity for monetary policy to act in conjunction with fiscal and other measures to stem the growth risks.

35. Against this backdrop, the stance of monetary policy in this review is intended to:

provide an appropriate interest rate environment to support growth as inflation risks moderate;

contain inflation and anchor inflation expectations; and

continue to manage liquidity to ensure adequate flow of credit to the productive sectors of the economy.